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Accounting, Advisory, Tax, Estate & TrustWed, 28 Sep 2016 19:17:38 +0000enhourly1http://wordpress.org/?v=3.2.1Bank of Canada – FSR Dec 2012http://www.mycfoweb.ca/2012/12/bank-of-canada-fsr-dec-2012/
http://www.mycfoweb.ca/2012/12/bank-of-canada-fsr-dec-2012/#commentsSun, 16 Dec 2012 18:28:03 +0000Chris Horlacherhttp://www.mycfoweb.ca/?p=650Back in April, I reviewed a document called the “Financial System Review”, published semi-annually by the Bank of Canada. Due to the dire warnings contained therein, I thought it necessary to produce a more user-friendly summary of the information the Bank presented to the public. The information the Bank provided was top-notch, though I disagreed with some of their interpretations.

Since this is a regular publication, I think it will be useful to keep readers abreast of all the developing issues here in the Canadian and global economy. It affects everyone and so it will be important to have an understanding of the crises looming overhead so that you’re able to act effectively to guarantee the financial prosperity of you and your family.

In the new Financial System Review, published December 2012, the Bank revisits many of the same risks they brought up in the December 2011 issue and comments on their relative improvements or deterioration. Overall, the picture is not good and Canadians may soon be facing a crisis similar to that of the United Kingdom, Europe and the United States.

Macrofinancial Conditions

Over the last year there has been a severe deterioration in economic indicators throughout Europe and where last year’s FSR focused on the USA, the Bank’s attention has now shifted to the Eurozone. When I reviewed the 2011 FSR, I concluded that the Bank will continue interpreting crises in their favour, calling for ever more central bank action in the markets. In this issue, the Bank does not disappoint, calling for ever more stimulus and centralization.

…additional monetary policy stimulus announced by several central banks – including the U.S. Federal Reserve, the European Central Bank (ECB), the Bank of Japan and the Bank of England – will help support global economic growth… plans for establishing a single banking supervisor need to be supplemented with other critical elements of a banking union – namely a framework for common deposit insurance and cross-border bank resolution… including a fiscal transfer system and some form of mutualisation of sovereign debt.

Why the Bank believes further monopolization of the financial sector will improve performance is never explored, it is taken as a foregone conclusion that centralization improves the economy. Common deposit insurance and banking regulations did not prevent a crisis from developing in the United States so one must wonder why the Bank proposes such measures in the face of so much evidence that centralization adds nothing to the stability of the global financial system.

Nevertheless, the Bank decides to take the credit for what minor improvements (called “green shoots” by the media) have been found in remote sectors of the economy and praises the actions taken thus far by other central banks, including the recent announcement of QE3 by the Federal Reserve. This is an open-ended program to create $40 billion in new currency every month until they are satisfied with the economy’s performance. Such actions further assault the dollar’s status as the world’s reserve currency by demonstrating to the world that its supply is theoretically unlimited.

Key Risks

The previous FSR discussed five key risks in the global economy. In this edition they have been reduced to four, but this should not be taken as an indication that any dangers have actually subsided.

Euro-Area Crisis

This is “the principal threat to financial stability in Canada” according to the Bank. Like many commentators in the financial media, the Bank does mention that the ECB’s monetary policies have only bought time (i.e. “kick the can down the road”) and have not addressed the real fundamental problems facing the European economy. This problem lay in the enormous debts incurred by Eurozone members.

The quality of loans on bank’s balance sheets continues to deteriorate, with impairment charges at Spanish banks nearly doubling over the past three years. Further losses are likely, as the number of non-performing loans is highly elevated and increased defaults are likely.

The proposed solution by the Bank is further monopolization of the banking industry in Europe. This is a rather odd suggestion as I previously mentioned. The kind of centralization the Bank recommends was present in the United States and did not seem to be able to deal with the 2008 crisis. However this is quite in line with my prediction that the Bank will interpret facts to favour its own agenda.

Deficient Global Demand

As most institutions are big believers in the school of economic thought known as “Keynesianism”, it is not surprising that this is brought up as a risk. Under Keynesian-style thought, economic crises are a blend of insufficient consumer demand, idle resources and investor irrationality. It never probes deeper in to the “why” of these situations and always comes down in favour of more government and central bank action in the marketplace. In this section, the Bank is true to Keynesian form.

In the first paragraph, the Bank places blame on the savers of the world for not doing their part in helping to boost aggregate demand (a.k.a. consumption spending). They expected the people of other nations to increase their spending in proportion to the decline in western spending. Instead people are doing exactly what they need to be doing when they find themselves overextended; save and pay down debt (“deleveraging”). Keynesian economics expects people to be sacrificial lambs to a statistic known as Gross Domestic Product (GDP), which is regarded as the end-all, be-all statistic for measuring economic growth. For reasons I will not go in to here, it has long been debated whether this particular measure of the economy provides anything useful at all from a policy perspective.

The section goes on to mention the explosion in debt in many advanced economies.

Government indebtedness is high and on an unsustainable upward trajectory in a number of major advanced economies – including the United States and especially Japan.

Of course, this is a direct result of the government’s attempts to replace lost consumer demand by borrowing vast quantities of funds from the central bank and private sector debt markets and spending it in to the economy. Such action boosts GDP, but has limited actual stimulative properties that should be clear to everyone by now. As pointed out in a recent 2010 study, there are diminishing returns to GDP growth as debt-to-GDP ratios increase past the 60% threshold.

Canadian Household Finances and the Housing Market

Last year’s report focused heavily on this subject and they continue the discussion here. The section leads by stating what we should all know at this point.

The most important domestic risk to financial stability in Canada continues to stem from the elevated level of household indebtedness and stretched valuation in some segments of the housing market.

The beginnings of a correction in the housing market are already starting to show, with sales of existing homes declining due to changes in the mortgage lending rules undertaken over the past year. In my report on the 2011 CMHC financial statements, I predicted that these changes would accelerate the arrival of a correction in the housing market and evidence of this is already starting to come in.

Household debt figures are still in the stratosphere and with the growth of credit beginning to moderate, it appears that Canadians may be tapping out.

Such extreme amounts of leverage make private homeowners particularly susceptible to increases in the interest rate or changes to their income. Nevertheless, Canadians are managing to hold on at the moment with loans in arrears improving slightly over last year.

The Bank points out that the share of new mortgages in 2012 with fixed interest rates has been close to 90%, which is significantly higher than the 55% average it was during the 2010-11 period. This will provide some measure of protection against interest rate volatility, but not much since the typical fixed rate mortgage is only fixed for 5 years. Nearly a third of all outstanding mortgages are at variable rates and thus those borrowers are fully exposed to interest rate risk.

In attempting to explain why housing activity was so elevated, the Bank makes a particularly confused statement:

Housing activity has been elevated relative to historical norms for close to a decade, supported in particular by strong resale and renovation activity.

This is completely circular; they may as well say that housing activity is elevated because housing activity is elevated. It does absolutely nothing to explain what was driving this change in behaviours. Of course, if they really did explore the driving forces behind this, they would necessarily wind up pointing the finger at themselves and this would not fit will with their projected image as economic saviours.

Despite the moderations in resale activity, new housing starts continue to rise along with prices, which are now 16% above their previous peak in August 2008.

It’s rather amazing to see television commentators deny the existence of any kind of distortions in the housing market when the price/income ratio is 25% higher than it was during the peak of the 1980’s housing bubble.

Another item of significance is the huge supply overhang of multi-unit dwellings (townhomes and condominiums), making this sector of the industry particularly prone to sudden downwards movements in price.

In fact, the correction in this segment may already have begun.

As in the previous FSR, the Bank performed a stress test based on a 3% rise in the unemployment rate and a six-week increase in the average duration of unemployment. The results were no different, with loans in arrears rising to 1.2%, enough to wipe out all the Canadian Mortgage & Housing Corporation’s capital if those loans transition to default.

Low Interest Rate Environment in Major Advanced Economies

The most interesting part of this risk is that the Bank can talk at length about it and never once implicate itself or other central banks. The Bank is the one entity most responsible for creating such conditions and the numerous stimulus programs (a sample of which are outlined below) are directly responsible for creating this risk.

Despite completely ignoring their own hand in creating this environment, the Bank does go on to make an astute prediction.

Significant volatility and losses may result if investors try to exit from some asset classes en masse in response to a change in perception regarding the interest rate environment.

Indeed, if people begin to perceive that a rapid increase in interest rates is on the horizon, then the currency and bond markets will experience a massive sell-off causing chaos that could easily metastasize into severe devaluations in a number of key currencies such as the US dollar, Euro, Pound and Yen.

Conclusion

The 2012 FSR is not so different from the 2011 FSR I previously reviewed. The identified risks are substantially the same and I did not expect them to change either. The updated statistics provide a useful picture of the Canadian and global economy and the Bank does a relatively good job at pointing out all of the pertinent data. Unfortunately, the Bank continues to ignore its own role in creating these conditions and proposes that an even stronger banking monopoly be established in order to better control the decline of western economies. Their final suggestion is that the new BASEL III rules be implemented globally. What they should have realized is that a highly integrated, centrally controlled financial system cannot help but create distortions in the marketplace due to the calculation problem, first theorized by the famous economist Ludwig von Mises.

Other Articles in This Series

]]>http://www.mycfoweb.ca/2012/12/bank-of-canada-fsr-dec-2012/feed/0Annual Report – OTPP 2011http://www.mycfoweb.ca/2012/10/annual-report-otpp-2011/
http://www.mycfoweb.ca/2012/10/annual-report-otpp-2011/#commentsSat, 06 Oct 2012 20:12:18 +0000Chris Horlacherhttp://www.mycfoweb.ca/?p=616The 21st century has been one marked by low interest rates and even lower real interest rates. In response to the dot-com crisis of 2001 Western governments embarked on a policy of low interest rates in order to stimulate the economy. While those on Wall St. praised this move, which allowed them to lever up to new heights at reduced costs, others are suffering greatly from this policy that has now been adopted by central banks and governments worldwide.

Teachers enrolling in the OTPP in the year 2011 will be trading in a retirement account potentially worth over $1.3 million for benefits worth about $425,000. Such is the cost of the illusion of safety in today’s precarious world of finance.
Government interventions such as artificially-reduced interest rates upset the natural order of the marketplace. A market is a dynamic and complex system of human interactions that brings forth a structure of production manifested by voluntary interactions and the price discovery mechanism. Interference in this process only directs resources away from their most efficient uses towards politically-expedient ends, often resulting in future turmoil when unsustainable projects must finally be liquidated. There are always winners and losers in any market intervention because no new resources are created, they are only shifted to one party at the expense of another.

Low interest rates may benefit financial institutions such as banks and hedge funds, however insurance and defined-benefit pension funds suffer greatly. Such is the nature of these kinds of organizations, which must anticipate future expenses and set aside enough money in the present to be able to afford them.

How Pensions Work

Pension plans began as an incentive offered by companies looking for the best executives and were initially only granted to the top managers in an organization. This practice continues today under the name of Supplemental Executive Retirement Plans (SERP’s). During the post-war period though, western companies and governments began offering everyone defined benefit (DB) pension plans and many employees happily accepted the promise of a guaranteed retirement income.

…if the OTPP were a Province, it would be the third most indebted Province in the country.
In order to provide these benefits, pension plans consult actuaries who calculate the present value of the liabilities these plans are assuming. Such liabilities consist of the obligation to provide future payments of cash, medical and dental services, survivors and death benefits and a host of other features that will all cost the Plan money. These future costs are translated to the present through a process called “discounting”, which relies on a rate of return in order for the calculation to take place. The lower the rate of return, the less of a difference there is between present and future money. Hence, low interest rates increase the present value of the costs these Plans have assumed. When Plan assets no longer outweigh the present value of their liabilities, the Plan is considered underfunded. At the same time, low interest rates reduce the rate of return on Plan assets and thus make it even harder for Plans to balance their assets and liabilities.

The Best Laid Schemes of Mice and Men

The Ontario Teachers’ Pension Plan (OTPP) has its roots back in 1917 and has grown in to one of the largest pension funds in Canada. It provides a particularly illustrative example of the difficulties faced by DB pension plans worldwide. It has over 180,000 active contributors and provides benefits to over 120,000 pensioners. In 1990, changes to the Plan resulted in significant asset diversification away from Ontario Provincial Bonds in to real estate, stocks and even commodities. This strategy appeared to work for a time, with the Plan reaching 100% funding by 1996. Since the year 2000 though, the financial health of the OTPP has rapidly deteriorated.

As you can see in the chart above, the OTPP is facing a severe funding problem. It is now over $45 billion behind in its funding requirements. To put the size of this deficit in to perspective, if the OTPP were a Province, it would be the third most indebted Province in the country (after Ontario and Quebec). New Plan members are assuming a $250,000 funding requirement in order to pay for current and soon-to-be pensioners. This is over and above their own personal funding requirements, which are quite significant as the table below indicates.

Such a huge deficit could be indicative of a failure of management to produce adequate investment returns; however this is not the case. The OTPP is actually one of the best performing pension funds in the country, averaging over 10% per year for the last 20 years.

Such nice returns don’t come without a price tag though. Last year Jim Leech, CEO, received compensation totalling over $4.3 million. Neil Petroff, EVP Investments, received $3.5 million. While this is not out of line with compensation received by other fund managers of similar size, one must take note of the fact that the OTPP does not generally outperform the market. Furthermore, as we will soon see, the returns to plan participants are actually far lower. It would seem preferable to simply invest in a market index ETF due to their lower costs as well as the fact that you would enjoy the full benefit of all the funds you invested rather than receiving an annuity that may be worth far less than what you put in. Unfortunately for teachers, enrollment in the OTPP is mandatory.

Demographic Imbalances

Shifting demographics are also playing a large part in increasing Plan liabilities, as the image below indicates.

Increasingly, the burden to support pensioners is falling on the shoulders of a smaller and smaller group of working teachers. Current expectations are that this ratio will continue to decline from the present 1.5:1 to 1.3:1 by the year 2020. As class sizes have not grown significantly it cannot be argued that teachers are becoming more productive and thus able to support these more narrow ratios. The growth in the amount of pensioners has simply been outpacing the growth in the number of active teachers for some time. That may be due to the following factors.

As a result, benefits being paid out of the fund now greatly outpace contributions going in.

All of this indicates that the Plan is suffering from unrealistic assumptions about the amount of retirement benefits that can be sustained by the Plan. Furthermore, the assumptions used in calculating the actuarial liability may be too optimistic. For instance, it is assumed that the inflation rate will remain at 2.15% even though in the past a much higher 4% assumption was used. A higher rate of inflation further reduces the discount rate thus growing the liability all that much faster. In fact, in a sensitivity analysis, the OTPP calculates that a decrease in the discount rate of only 1% would add another $25 billion to their liabilities.

The OTPP is suffering from the same error many DB pension plans have made; promise more than they are able to deliver. As a result, too many teachers are now retiring too early and collecting benefits for much longer than initially anticipated. Without significant changes to when teachers can collect benefits and how much they will ultimately receive, the financial position of the OTPP will continue to deteriorate until it won’t be able to fund anyone’s retirement.

Cost/Benefit Analysis

When making decisions between two or more alternatives it’s instructive to perform a cost-benefit analysis to determine the best course of action. Fortunately when it comes to pensions it’s rather easy to perform the necessary calculations. What we are comparing is the value of the Plan contributions vs. the value of benefits received. To do this we compare the future value of a teaching career’s worth of contributions, to the lump-sum value of that teacher’s pension benefits as of the same date. What we find is rather alarming.

Teachers enrolling in the OTPP in the year 2011 will be trading in a retirement account potentially worth over $1.3 million for benefits worth about $425,000. Such is the cost of the illusion of safety in today’s precarious world of finance.

Conclusion

Without significant changes to when teachers can collect benefits and how much they will ultimately receive, the financial position of the OTPP will continue to deteriorate until it won’t be able to fund anyone’s retirement.
In ten years, the OTPP has gone from being a fully funded pension to over $45 billion in debt due to deteriorating market conditions, demographics, and a benefit plan that simply cannot be sustained. Teachers just beginning their careers are now being burdened with not only supporting their own retirements, but also filling in for the inadequate contributions of their predecessors. It is a great example of why many employers are now switching to defined contribution plans, which don’t suffer from the same actuarial funding requirements.

]]>http://www.mycfoweb.ca/2012/10/annual-report-otpp-2011/feed/0Annual Report – CMHC 2011http://www.mycfoweb.ca/2012/07/annual-report-cmhc-2011/
http://www.mycfoweb.ca/2012/07/annual-report-cmhc-2011/#commentsSun, 15 Jul 2012 20:35:03 +0000Chris Horlacherhttp://www.mycfoweb.ca/?p=518Dear readers, it’s happened again. The federal government is once again revising its rules on mortgage lenders. The new revisions are mostly a repeat of the changes they made back in January 2011, and that I reported on in a previous article. Maximum amortization periods were reduced by another 5 years, and maximum home equity loans were reduced by another 5% of the home value and apply only to new mortgages made after July 9, 2012.

“If the CMHC was made to stand on its own we see that it has consistently lost money for every year that financial data is available… it technically bankrupted itself over 10 years ago.”All of the criticisms I leveled at the original modifications still stand. I would like to make one additional point though and that is that if these changes were made with the intention of preventing a housing market crisis in Canada then the architects of this solution are sorely mistaken. Our housing market, like all other market bubbles, is dependent on what investors refer to as the Greater Fool Theory. In order to keep housing prices continually rising, demand growth must continually outpace the growth of supplies. By making things more difficult for prospective home buyers to finance their purchases, demand will necessarily soften and this throws a bucket of cold water on the now decade-long fantasy that owning a hugely expensive and depreciating asset is the road to true wealth.

At the epicenter of this entire trend is the Canadian Mortgage and Housing Corporation, a behemoth of a crown corporation. It performs the same function as the notorious US mortgage insurers Fannie Mae and Freddie Mac. Due to the sheer size of this organization, it behooves us as Canadians to keep a close eye on what the government is doing here because we are all ultimately on the hook for the CMHC’s debts and other obligations, should it not be able to handle them on its own. To that end I will be performing a regular analysis on their annual financial statements in order to report on their status and highlight what I believe are significant risks that they present to the average Canadian taxpayer.

Assets

The CMHC is an insurance company, and if you know how an insurance company works then you’ll be immediately troubled by what is going on with their assets. I’m talking about the $257 billion in mortgages that are on the books, representing 88% of their total assets. This is a problem because of the nature of this particular insurance company. Remember, the CMHC insures against mortgage defaults, providing lenders with a safety net that guarantees that they will never lose the principal they lent out. In the event of a severe downturn in the mortgage market, claims will start pouring in. The CMHC (nor any kind of insurance company) never possesses enough cash to cover all of these potential liabilities, they invest it. The problem here is that the CMHC has bought the very same assets they are insuring against. If the mortgage market collapses, so too will the value of the assets of the CMHC, making them extraordinarily difficult to liquidate in order to raise the cash necessary to pay out their claimants. It’s a catch-22 that spells potential disaster and deeply impairs their ability to actually insure against this particular type of credit risk. If we adjust the CMHC’s total insurance and assets to look at their net exposure and see how well their assets cover the amount of guarantees they’ve made we see that this ratio has grown tremendously, from a low of 3.85 in 2009 to slim 8.81 in 2011. This was the result of drastic actions taken by the CMHC shortly after the US housing bust in order to ensure that there was no panicked sell off here in Canada. These actions essentially boiled down to “guarantee everything in sight”, and the results speak for themselves.

Another point of concern is how quickly these guarantees are growing when compared to their assets. Total insurance-in-force is up 10.3% from last year, while total assets only grew 1.4%. This is simply unsustainable, particularly when 88 cents of every dollar of assets added is exposed to the same risks that the CMHC is insuring against.

Further compounding this problem is the razor-thin capital cushion that the firm is carrying. Assets to equity stand at an anemic 24:1, meaning a 4.1% loss on their assets will completely wipe out the firm’s capital. In reality, it will take even less than that due to the minimum capital requirements that all Canadian insurers must follow.

Liabilities

The CMHC’s liabilities present further problems with the fact that the company is highly indebted to both private and government creditors. You may have heard of the story that circulated this year exposing the fact that Canadian banks received $114 billion in government assistance during the collapse of the US housing market. The CMHC’s statements reveal that from 2007 to 2009 their borrowings from the government increased from $4.4 billion to a whopping $69.8 billion and have stayed at around that level ever since. Interest-bearing liabilities represent an incredible 96% of total liabilities. Interest expenses are also 74.3% of total expenditures and swallow up 63.3% of total revenues. This makes the CMHC incredibly sensitive to interest rate fluctuations. An 0.6% rise in the cost of servicing this debt would completely wipe out net income (the real picture is even worse, but more on that in the income section of this report).

Canada Mortgage Bonds*

(in millions of dollars)

Amount Maturing

Yield

2012

37,737

4.30%

2013

35,254

3.41%

2014

35,918

2.53%

2015

30,527

2.51%

2016

32,059

1.98%

2017-2021

27,878

3.36%

Total

199,373

3.04%

*In addition to these amounts is a further $2.2 billion borrowed at an average rate of 4.60%.

Borrowings from the Government of Canada*

(in millions of dollars)

Amount Maturing

Yield

2012

2,214

3.06%

2013

24,157

3.69%

2014

27,929

2.71%

2015

2,246

3.56%

2016

268

6.26%

2017-2021

1,705

6.77%

Thereafter

2,244

7.88%

Total

60,963

3.46%

*There is a further $6.6 billion in government borrowings at an average rate of 2.69%.

” There is a built-in assumption by the CMHC that a significant drop in the lifespan of the average Canadian is more likely than a rise in mortgage default rates.”Due to the fact that the CMHC generally borrows on 5-year terms, rising interest rates could have a material impact faster than expected. Not only do higher interest rates mean higher costs to service their debt, it will also impair the value of their mortgage portfolio resulting in further losses. This is likely a factor in the Bank of Canada’s decision to maintain the low interest rate environment in Canada. There is simply too much debt (both public and private) to allow rates to rise because of how addicted to debt the country has become. Furthermore, if private lenders aren’t willing to refinance the debt at these low rates and demand the return of their principal then the federal government must step in as guarantor of the CMHC’s debts. However, if investors aren’t willing to finance the CMHC anymore at the low rates they’re offering, they certainly won’t be willing to finance the government, who typically borrows at the lowest rates in the country. It will ultimately fall to the Bank of Canada to begin financing the CMHC’s debt (either directly, or through the Treasury) and this will cause a massive expansion in the monetary base of Canada, which presently stands at $67.4 billion and bring with it the risk of a substantially increased rate of inflation.

Income

As I’ve already mentioned, most of the CMHC’s revenues are swallowed up by interest expenses. What many people don’t know is that the CMHC has technically been on government welfare since at least the year 2000. They have received a total of $26.5 billion in federal assistance since the turn of the new millennium. If the CMHC was made to stand on its own we see that it has consistently lost money for every year that financial data is available. This, during the greatest bull market in housing the country has ever seen. In the year 2000, without assistance, the CMHC would have sustained a net loss of $1.6 billion. It only started the year with equity of $0.5 billion and so it technically bankrupted itself over 10 years ago. Adjusting for federal assistance we now see that interest expenses rise from $0.63 to $0.75 of every dollar brought in.

Insurance & Guarantees-in-Force

These items do not appear on the balance sheet but nonetheless should be looked at because they are the primary component of the CMHC’s operations. They represent a source of both revenue and liabilities, since they collect fees on the total amount but any portion of these could immediately be transferred to their liabilities as claims come in. Despite the revisions in mortgage rules implemented by the federal government, the CMHC is showing absolutely no signs of slowing down.

I find it odd that the government even bothers putting a constraint on the amount the CMHC can cover since it’s obvious that the limits will simply be raised any time they’re approached. The total amount covered now stands at $567 billion. Just as a point of reference, the national debt is $587 billion. Based on the provision for claims that the CMHC has set up, they only expect to pay out 0.18% of the total amount of risk they’ve taken on. This may be inadequate, as they also report in the financial statements that 0.4% of insured mortgages are already in arrears. Next stop is default, and a CMHC payout to the creditors.

Industry Comparison

It also helps to compare how the CMHC is doing to other similar companies to see whether or not their status is unusual. For this I have gathered up data from the property & casualty and life insurance industries (courtesy of the Office of the Superintendent of Financial Institutions), as well as data from Fannie Mae’s 2006 financial statements, which should provide a good picture of what it looked like right before it collapsed.

CMHC 2011

P&C 2011

Life 2011

FM 2006

Assets to Equity

24.14

3.48

14.71

20.33

Insurance to Equity

46.89

N/A

N/A

57.40

Interest Coverage

1.24

152.34

3.86

1.11

The interest coverage ratio (EBIT, divided by total interest expenses) is quite telling. The property and casualty figure is very healthy and the life insurance figure is within normal limits, but Fannie Mae is at positively rock-bottom levels with the CMHC right there with them. If a normal company had a ratio this low there would be alarm bells going off in all of the offices because they are struggling just to keep their heads above water. The CMHC is also extremely leveraged when looking at how much equity they have to support their assets. Granted, claims are much more likely to occur in the property & casualty insurance markets than they are in mortgage insurance however with life insurance it’s a different story. There is a built-in assumption by the CMHC that a significant drop in the lifespan of the average Canadian is more likely than a rise in mortgage default rates.

Conclusion

There is much to be concerned about with the financial health of the CMHC. The government is undertaking measures to stabilize the housing market but the evidence shows that they are not having the desired effect. Furthermore these measures only affect new mortgages, not existing ones. The CMHC remains highly susceptible to even a slight increase in the rate of mortgage defaults, or a rise in interest rates. With the federal government, and ultimately the Canadian taxpayer, on the hook for all of the CMHC’s liabilities we could soon find ourselves in an extremely difficult financial position.

]]>http://www.mycfoweb.ca/2012/07/annual-report-cmhc-2011/feed/0Something Venturedhttp://www.mycfoweb.ca/2012/07/something-ventured/
http://www.mycfoweb.ca/2012/07/something-ventured/#commentsSun, 01 Jul 2012 23:51:07 +0000Chris Horlacherhttp://www.mycfoweb.ca/?p=509Venture capital is an incredibly important part of any economy. After all, where would we be without the entrepreneurial investors that built Silicon Valley and our modern technological age? Finding people with the means and motivation to see your project through is a key component of any successful business venture. Likewise, investing in start-ups can be extremely profitable if one knows how to identify businesses with high growth potential.

Until recently, connecting entrepreneurs with venture capitalists has been a difficult task. Investors would often form private equity companies and hope that said organization would attract promising businesses. The internet now makes this process much easier.

Enter Whitespire Venture Capital Network (WVCN). This website is a private online network connecting entrepreneurs looking for resources with investors seeking alternative investment opportunities. Accessing private capital has never been this easy. Entrepreneurs create their online profile consisting of text, photos, videos and other data and post it on the WVCN website. Investors can then search the online database to find attractive business investment opportunities. The investor will then contact the entrepreneurs they’re interested in and work out a deal. The site also provides links to experienced professionals who can aid in every step of the transaction in order to ensure a fair and equitable relationship.

WVCN is an online Dragon’s Den, in a sense. It attracts businesses of many types and stages of development. One can easily find companies looking for seed capital, start-ups, early growth phase and even mature companies looking to take on a new project. The site is not affiliated with any venture capital corporations or investment groups and merely acts as a match maker. Thus it provides a neutral space where investors and entrepreneurs can create wealth and opportunities together.

]]>http://www.mycfoweb.ca/2012/07/something-ventured/feed/0Danger Ahead! Says the Bank of Canadahttp://www.mycfoweb.ca/2012/04/danger-ahead-says-the-bank-of-canada/
http://www.mycfoweb.ca/2012/04/danger-ahead-says-the-bank-of-canada/#commentsFri, 06 Apr 2012 16:09:31 +0000Chris Horlacherhttp://www.mycfoweb.ca/?p=473One typically doesn’t look to government bureaucracies to receive hard-nosed, objective discussions on the economy. Far too often official reports are skewed to paint a much rosier picture than what is unfolding in reality. Case in point the repeated denials from Ben Bernanke and the Federal Reserve, Fannie Mae and various oversight committees that the US housing market was anything but an excellent place to invest your money. Imagine my surprise when the December 2011 Financial System Review, published semi-annually by the Bank of Canada, landed in my inbox and I discovered that it contained a very sobering look at Canada’s economy and the many systemic risks we are facing! It’s not surprising that this report was not picked up by the main stream news, because if they did the popular opinion of Canada’s invincible, recession-proof economy, may begin to crumble.

The report identifies five key areas of economic risk faced by Canada in particular, which I will summarize here. We begin with a brief analysis of global macrofinancial conditions and are immediately told that the Bank’s economic outlook in all areas has been revised downwards significantly over the past six months. Europe is judged to be in a recession and recovery prospects in the USA look bleak. The report points out that, amazingly, Canadian bank stocks are still trading at 70% above their book value, whereas US, UK and Euro bank stocks are well below this level. The Bank states that this is due to investors placing higher confidence in Canada’s banking system, however if you’ve read my reports on the Canadian housing market (and look at the facts presented in this report) you might also come to the conclusion that much of the confidence is unfounded and could rapidly deteriorate as well.

The report also confirms the statement made by many investment experts, such as Peter Schiff, that capital flight in to government debt is crowding out private investment. This is part of what is prolonging the depression. Instead of financing economic recovery through investment in new ventures, projects and economic reorganization, primary dealers are instead simply financing the growth of government. This only further dampens the private economy and forms the vicious cycle that is sure to keep the economy in a recession.

As previously mentioned, the Bank identified five major areas of risk facing the global economy, which are as follows:

Global Sovereign Debt

It’s somewhat telling that the Bank decided to list this first, as it illustrates just what a massive problem this is becoming. Tens of trillions have been invested in the debt of governments who are now facing massive budgetary and fiscal crises. An “adverse spiral” has been rated the principal threat to domestic financial stability and that this risk has already partly materialized. Incredibly, the Bank even considers the eventuality of the US dollar losing its reserve currency status.

Until now, debt-service burdens in both [USA and Japan] of these countries have been held down by favourable borrowing conditions – stemming in part from structural factors such as the high level of liquidity in the market for US Treasuries, the role of the US dollar as the international reserve currency and high domestic savings in Japan. There remains, however, a small but significant risk that this advantage could be lost if investor confidence suffers from repeated failure to undertake the needed fiscal consolidation.

Unfortunately, the Bank considers the numerous bailout and liquidity measures undertaken by central banks and the IMF to be “steps in the right direction” even though they specifically note that any relief that these measures provided was temporary at best and that the situation in Europe continues to deteriorate, with yields on sovereign debt moving sharply higher in a number of Eurozone members. The chapter concludes that the debt crisis “can be resolved if policy-makers address the situation in a forceful manner… based on credible fiscal arrangements and enhanced governance.” In other words, even more government involvement in the financial system. This has already proven to be useless, as the Bank admitted in an earlier segment of this chapter so one has to ask why they believe that more of the same is necessary.

Economic Downturn in Advanced Economies

In the next risk, the Bank notes what everyone should now be aware of; global economic activity is slowing down markedly. Household and bank deleveraging is dragging the world economy deeper and deeper in to recession. Further downturns in advanced economies would have a substantial impact on Canadian businesses, households and financial institutions transmitted through bank losses and deteriorating credit quality. The Bank notes that while some banks have increased their capital buffers other banks still have razor-thin cushions and high exposures to underperforming assets. The obvious conclusion we should reach from this is that there continues to be massive, systemic risks in the financial system that could send waves of destruction throughout the global economy.

There are also concerns over asset quality for the global banking sector. The report notes that the US real estate market is vulnerable to further deterioration and that stagnant wage growth is impairing the ability of borrowers to service their mortgage debt. A massive overhang in the supply of housing also persists. Banks have foreclosed on a large number of properties and are unable to liquidate them at what the Bank calls “reasonable prices”. However, a reasonable price would be one where buyers would be willing to buy. The fact that banks possess this huge stock of houses actually indicates that they’re asking unreasonable prices for them. Non-performing loans in the UK and Eurozone are at nearly 7% of total loans and climbing. In the US these loans now represent about 2.3%, down from a high of about 3.5% in 2009, and in Canada it is at about 1% of total loans and showing a small decline since 2010. Despite Canada’s low levels, the Bank concludes that:

If economic activity declines significantly, a growing number of Canadian households and businesses would experience financial difficulties, which would translate into an increase in loan losses at financial institutions. If banks curtail credit, this would trigger an adverse feedback loop through which declines in economic activity and stress in the financial system would reinforce each other.

This statement mirrors what I had predicted in my article The Canadian Moral Hazard Corporation, where an economic downturn would impair the quality of mortgages, causing a string of defaults to ripple through the banking system, in turn necessitating massive bailouts and debt monetization by the Bank.

Global Imbalances

The report also notes that current account imbalances (trade surpluses and deficits) remain an important source of risk. These imbalances, and the lack of exchange rate flexibility that allows them to persist, have created a global economic configuration marked by unsustainable debt accumulation in some advanced economies that is counterbalanced by asset accumulation in some emerging-market economies. While the report doesn’t mention any specific names, it could not be clearer that they’re referring to China’s accumulation of trillions of US dollars and US treasuries. The Chinese renmimbi is being closely managed by the Central Bank of China at an exchange rate of 6.4 to the US dollar and has held it down for over a decade. In the 1980’s the renminbi was intentionally devalued against the dollar as China pursued their plan of creating an export-driven economy. This manipulation has ensured that the US dollar remained overvalued against the renminbi and the consequence of this has been US dollars being used to purchase Chinese goods at tremendous rates. While devaluing a nation’s currency against those of their trading partners has long been held as a way to stimulate exports, one has to wonder if forcing exporters to accept less than fair value for their products is really conducive to creating a healthy economy.

The Bank is concerned, and rightly so, that this imbalance could unwind in a rapid and disorderly way. This has been referred to as a “decoupling” scenario by many investment industry experts. Large and abrupt movements in the value of the renminbi would impose significant losses (and gains) on financial institutions worldwide. The Bank also stated that the reserve accumulation in surplus countries could distort the financial system of those countries, resulting in asset price bubbles. This is becoming apparent in China, as they have constructed entire cities that cannot be occupied at current prices. It appears that China, who has experienced year over year GDP growth in excess of 8% for many years, may be in for a correction very soon.

Low Interest Rate Environment in Major Advanced Economies

The report further notes that interest rates are at or near their all-time historic lows and that this is likely to persist. According to the Bank, “accommodative monetary policy is necessary to support the global economic recovery” and this is consistent with what we’ve heard coming out of the Federal Reserve. This simply isn’t the case though. The crisis was brought about by central banks setting interest rates lower than the market would bear so further suppression is unlikely to induce the necessary repairs. Here the Bank really displays that despite knowledge of the facts, it lacks the theory necessary to properly interpret them and they wind up making the wrong diagnosis and prescribe remedies sure to only further the harm done to the economy.

The Bank notes that low interest rates put pressures on institutional investors like pension and insurance funds. Low rates increase the actuarial value of their liabilities while simultaneously reducing the return on their assets. This can lead to excessive risk-taking by these institutions as they attempt to balance their assets and liabilities.

What the Bank doesn’t mention though, is the inflation risk brought about by low interest rates. Low rates stimulate increased borrowing, which in turn expands the monetary supply. The reason why banks became so highly leveraged to begin with was the endless supply of cheap credit from central banks. It’s unfortunate that this risk isn’t explored in the report because it represents a much greater, and more fundamental, issue facing the global economy. Realizing this also plants the seeds for recovery as it becomes obvious that what is needed is higher interest rates, which would stimulate retrenchment by banks and the liquidation of bad assets. Continuously low rates only prevent these imbalances from normalizing.

Unfortunately, a low interest rate environment is taken as a foregone conclusion and the Bank proposes measures that would further impair the ability of institutional investors to deal with the risks they face on an individual basis. Prescribed portfolios and the herding of capital in to more risky derivative products are suggested as a means of dealing with the risks produced by low interest rates.

Canadian Household Finances

The final risk begins by stating something that I have been saying myself for some time now, that “The rising indebtedness of Canadian households in recent years has increased the possibility that a significant proportion of households would be unable to make debt payments in the event of an adverse economic shock.” With all the other risks identified in the report, I would say that such a shock is now inevitable, the only question being at what time and from what direction it will arrive. The aggregate debt-to-income ratio is at a historic high and as of Q2 2011, now exceeds that of the USA and the UK.

This is a good measure of leverage that illustrates the ability of borrowers to service their debts. Canadians are now in an even worse position to be able to do this than two economies that have been ravaged the most by recent economic events. The Bank expects that this ratio is going to continue to rise, further endangering the financial condition of Canadians and making them even more susceptible to financial shocks. While aggregate credit-to-GDP ratios have been declining, they still remain at or above levels seen during previous recessions in 1990 and 1981. Furthermore, the amount of mortgages in arrears is also elevated.

The Bank points out, as I have in the past that Canadians are especially vulnerable to two inter-related events; a significant decline in house prices and a sharp deterioration in labour market conditions. Since most mortgages are insured, a moderate fall in house prices could initiate a negative feedback loop with the real economy, destroying household net worth, access to credit and other factors. Never does the Bank consider how this would affect the finances of the Canadian Mortgage Housing Corporation, but as I predict, it would be severe as well. Housing prices are far higher, relative to incomes, than they were during the last housing bubble and so a decline at this point appears inevitable.

The baseline price-to-income ratio of housing appears to be around 3.0 and we are currently at about 4.8. Based on these facts we are looking at a potential overall decline of 35% or more in average real housing prices. The Bank performed a stress test based on various assumptions about income growth, debt accumulation, unemployment and interest rates. They project that a 3-percentage point rise in the rate of unemployment, coupled with a six-week increase in the average duration of unemployment would double the proportion of loans in arrears from 0.65% to 1.3%. Based on my own analysis of the CMHC, if all those loans in arrears went in to default (which is the next step), it would nearly wipe out all of the capital of the CMHC. Also remember that bureaucracies are notorious for under-estimating adverse economic consequences and so the events simulated by the Bank could even be considered a best-case scenario. It is quite likely that the shock will be much, much worse.

Conclusions

The report is replete with facts and observations suggesting that Canada is in a dire economic situation that could rapidly deteriorate, with consequences being felt by every Canadian. Unfortunately it appears that they have failed to see the real destabilizing force behind all of the imbalances present in our system. It is the low interest rate environment, produced by the Bank itself that has led us to the precipice. While it is clear that those at the Bank have access to all of the necessary facts, they lack the understanding needed to prescribe real solutions to our problems and as a consequence they are likely to persist for much longer than they need to. Furthermore, the report confirms my fear that in the face of a real downturn the Bank will not be able to resist the urge to intervene and will only wind up compounding the damage that has already been done. The Bank continues to view itself as a benevolent planner rather than acknowledge its own role as a source of risk. They will continue to interpret events in their own favour and use them to justify further intervention in the market, which is just throwing gasoline on the fire.

]]>http://www.mycfoweb.ca/2012/04/danger-ahead-says-the-bank-of-canada/feed/0Planning with Inter-Vivos Trustshttp://www.mycfoweb.ca/2011/09/inter-vivos-trusts/
http://www.mycfoweb.ca/2011/09/inter-vivos-trusts/#commentsTue, 06 Sep 2011 16:27:40 +0000Chris Horlacherhttp://www.mycfoweb.ca/?p=384In the previous article, I discussed the many benefits of a testamentary trust. Trusts are potentially the most powerful tool in any estate planners toolkit. As stated in that article there were two types of trusts as far as the CRA was concerned and they were inter-vivos and testamentary trusts. The basic difference between the two is that an inter-vivos trust is created while the settlor is still alive. A testamentary trust is created by a testator, or by the last will and testament of a deceased taxpayer.

The CRA taxes inter-vivos trusts at the maximum marginal rate regardless of the amount of income earned and retained by the trust, while testamentary trusts are taxed at the applicable marginal rates. Don’t let the high marginal tax rates on inter-vivos trusts deter you from these though, because they’re potentially an even better planning tool than a testamentary trust.

In December of 1999, the Finance Department introduced legislation that would allow for two new types of inter-vivos trusts. They are the alter-ego trust and joint spousal trust. For those aged 65 and older, these trusts offer some very effective estate planning options that everyone should consider. These trusts are so powerful that they can even replace a will in its entirety, as the ownership and distribution of all your assets can be arranged long beforehand.

The Basics

In the past, a transfer of property to a trust would trigger the accrued capital gains on that property, thus resulting in a higher tax assessment in that year. The new rules allow this transfer to occur tax-free and the accrued capital gains are only triggered upon your death in the case of an alter ego trust, or on the death of the surviving spouse in the case of a joint spousal trust.

These trusts have very minimal requirements for formation:

You are 65 years of age or older,

Only you or your spouse are entitled to receive income or capital from the trust during the remainder of your lives.

There are limited income-splitting opportunities in these trusts, as the income from any assets in the trust will be attributed to and taxed in the hands of the person that contributed that asset. However there are many other benefits to consider.

The Benefits

Using a will or testamentary trust is a common technique used to distribute assets upon the death of an individual. Using these new inter-vivos trusts provide the following benefits:

Avoid Probate Fees – Assets distributed by way of a testamentary trust or by will are subject to provincial probate fees. In Ontario, this rate is 1.5%, the highest of any province. Assets held in an inter-vivos trust are not included in an individual’s estate and are therefore not subject to such fees.

Privacy – Anyone, after paying a nominal fee, can obtain the complete listing of a deceased individual’s probate application list, which lists all the assets of the deceased person. Assets held in a trust do not become public information.

Avoid Conflicts – With wills, your survivors are able to apply to the courts in order to overturn the provisions of your will if they feel they were not adequately provided for. These trusts avoid such conflicts and ensure that your assets pass to your beneficiaries in the way you intend them to.

Escape the 21-Year Rule – Every 21 years a deemed disposition of all the trusts assets triggers all the accrued capital gains and a tax liability. These trusts are only deemed to dispose of their assets upon your, or your surviving spouses death. The 21 year rule only activates after this point.

Successor Trustee – You can act as the settlor and trustee of the trust during your lifetime, as well as have your assets pass to another trustee upon your death or in the event of your mental incapacity.

Taxation

As already stated, inter-vivos trusts are taxed at the highest marginal rate, which is over 40% in Ontario at present. This is not an issue to wealthy families since they’re already paying the highest rates. However, as long as all of the income generated by the trust is distributed it will be taxed as income in the hands of the beneficiaries at their individual marginal rates. This may offer some tax saving opportunities.

Conclusion

Alter-ego and joint spousal trusts are a powerful method for individuals and families looking to protect their assets, minimize their tax burden, retain control and pass their assets to their successors in a private and cost-effective manner. At myCFO, we can aid in the formation and trusteeship of such trusts. Please call to find out more.

]]>http://www.mycfoweb.ca/2011/09/inter-vivos-trusts/feed/0Is it Time for a Testamentary Trust?http://www.mycfoweb.ca/2011/08/is-it-time-for-a-testamentary-trust/
http://www.mycfoweb.ca/2011/08/is-it-time-for-a-testamentary-trust/#commentsTue, 23 Aug 2011 20:12:08 +0000Chris Horlacherhttp://www.mycfoweb.ca/?p=373One thing that can go overlooked by many estate planners is the use of trusts. This is a pity, because trusts can provide significant tax and non-tax benefits to those that use them. The Canada Revenue Agency (CRA) recognizes two basic types of trusts that everyone should be aware of. They are the inter-vivos and testamentary trusts. The advantages of testamentary trusts is explored below.

The Basics

Trusts are legal entities, like corporations. They must file their own income tax return, called a T3 and exist separately from the people that created it. In order to create a trust, three roles must be played. These are the roles of settlor, trustee and beneficiary. The settlor is the person whose assets are to be entrusted to the trustee, and the trustee is to manage those assets for the sole benefit of the beneficiary. The settlor and the beneficiary may actually be the same person in some cases. When a trust is created, legal title to the assets are transferred from the settlor to the trustee. For this reason, careful consideration must be given towards the selection of a trustee. They should possess the necessary skills in order to manage the assets entrusted to them, as well as be an individual (or organization) that the settlor is comfortable handing their assets over to.

Testamentary Trusts

A testamentary trust is a trust that arises on the death of an individual whose will calls for the creation of such a trust. The terms of the trust will be stipulated in the will and provide for such things as the payment of income or capital or both to the beneficiaries. The payment of benefits can be fixed in the will or be left to the discretion of the trustee. This can have several advantages if the trust is to be professionally managed and intended to provide a long-term stream of income to the beneficiaries.

Taxation of Testamentary Trusts

As previously stated, a testamentary trust is treated as a separate taxpayer under the Income Tax Act and must file a return reporting the income, gains and distributions to beneficiaries made in each year. Taxes are payable in the province of residence, or situs, of the trust. This is typically the same as the residence of the trustees. Trusts will generally have a calendar year-end, but that is not a requirement. Payments and distributions made to the beneficiaries are generally deducted against the income and capital gains made by the trust but any net income remaining in the trust is taxable at the appropriate marginal rate as if the trust were an individual. This contrasts with an inter-vivos trust, which is taxed at the highest marginal rate regardless of the net income earned by the trust. Distributions are then taxed in the hands of the beneficiaries as income.

Although trusts don’t receive the personal deductions available to individuals, the graduated rates on testamentary trusts make it much more beneficial to retain income and gains in the trust rather than be taxed in the hands of the beneficiaries if it means realizing a lower marginal rate. This is the main tax benefit to putting income producing assets in a testamentary trust. Being a separate taxpayer, the income produced by the trust will not be added on top of the income produced by the beneficiaries and taxed at higher rates.

Because testamentary trusts arise on the death of an individual, there will be a deemed disposition at fair market value of all property held by the settlor under the Income Tax Act. This forces the realization of capital gains even though the property has not yet been sold. This gain is taxed in the hands of the testator’s estate. Furthermore, since the assets pass through the estate before arriving in the trust, probate taxes will also be applied. The estate plan will need to address these gains and how to pay tax on them. Testamentary trusts are, however, able to avoid double probate tax. Even though assets initially placed in a trust are subject to probate taxes, the trust can dispose of the property at a later date thereby avoiding a second round of taxes.

All trusts in Canada are subject to the 21 year deemed disposition rule in the Income Tax Act. This provision deems that all property held by a trust is disposed of at fair market value every 21 years and any gains created by such accounting are taxed at that time.

Non-Tax Benefits of Testamentary Trusts

One of the main benefits of trusts is that they provide property owners with a powerful way to ensure that their assets are applied in the manner they describe. Since the trustee has legal title to the assets it is easier to set up and administer how family members and other beneficiaries can access the property. The trustee can take care of any repairs and maintenance as well, provided the trust produces enough income to offset the required expenditures.

Depending on the terms of the trust, beneficiaries and third parties typically have no right to demand that the assets of a trust be handed over to them. This is particularly useful in creating a protective barrier around your assets from the claims of beneficiaries’ creditors.

Conclusion

The use of trusts is a powerful estate planning tool that has significant tax and non-tax benefits. They are particularly useful for wealthy families and individuals seeking professional administration of their assets, tax efficiencies and legal protection.

]]>http://www.mycfoweb.ca/2011/08/is-it-time-for-a-testamentary-trust/feed/0A Second Look at the CMHChttp://www.mycfoweb.ca/2011/08/a-second-look-at-the-cmhc/
http://www.mycfoweb.ca/2011/08/a-second-look-at-the-cmhc/#commentsMon, 15 Aug 2011 21:33:01 +0000Chris Horlacherhttp://www.mycfoweb.ca/?p=346The CMHC guarantee is a direct and unconditional obligation of CMHC as an agent of Canada. It carries the full faith and credit of Canada, and constitutes a direct and unconditional obligation of and by the Government of Canada. – 2010 CMHC Annual Report, p.86 ,http://www.cmhc.ca/en/corp/about/anrecopl/upload/2010AR_EN.pdf
If the above quote doesn't bother you, it should, because it represents a potentially massive amount of debt that will be shoveled on to backs of every man, woman and child in Canada. A government bureaucracy, staffed by unelected functionaries, has pledged over a trillion of your tax dollars as payments to investors should their decisions turn sour.
In The Canadian Moral Hazard Corporation I highlighted the issues faced by the Canadian mortgage and housing market. As a country we're faced with record high levels of debt in both absolute and relative terms, record high housing prices and record low levels of savings. Based on overly-rosy future outlooks, Canadians have by and large become extremely leveraged and could soon have little to show for it.
In order to really understand just what we're facing as a nation and how it will unfold, a closer inspection of the CMHC is needed. It's also instructive to compare the CMHC to other similar organizations. For this comparison, it will be appropriate to use Fannie Mae (FM) in its 2007 incarnation. The CMHC is essentially the Canadian-based clone of FM with only one major exception; the US-government had a choice whether or not to bail them out. FM was 50% owned by the US government and 50% publicly traded. The CMHC is, by contrast, a 100% government-owned crown corporation.
Raw numbers on their own aren't always useful, it's better to look at ratios and leverage ratios give us a good look as to how far down the debt-hole a company has ventured. So without further ado:

CMHC 2010

Fannie Mae 2007

Assets to Equity

25.64

20.05

Guarantees to Equity

73.46

65.63

Debt to Income

18.89

18.73

From the vital statistics above, it's obvious that the CMHC is in an even more precarious position than FM. It is more leveraged in every respect and so the conditions are ripe for a collapse in this company. Its exposures to credit, interest and market risk are extremely high and it appears that little is being done to correct this situation. Little can be done though since the contracts have been signed and promises already made to investors.
Further compounding the situation is the short-term nature of CMHC's debt. Much of which matures over the next few years.

Canada Mortgage Bonds

(in millions of dollars)

Amount Maturing

Yield

2011

36,152

4.07%

2012

38,956

4.30%

2013

36,128

3.40%

2014

36,025

2.53%

2015

31,008

2.52%

2016-2020

19,219

3.40%

Total

197,488

3.40%

Borrowings from the Government of Canada

(in millions of dollars)

Amount Maturing

Yield

2011

1,661

2.71%

2012

1,406

3.59%

2013

26,137

3.58%

2014

29,133

2.52%

2015

2,275

3.68%

2016-2020

1,442

7.18%

Thereafter

2,215

8.41%

Total

64,269

3.40%

Interest expenses are the largest line item on the income statement, making up 68% of all expenses. Rising interest rates will quickly wipe out what little net income the CMHC is still making, further endangering the company. If they start realizing losses, the company will either have to start selling off its assets or borrow even more at higher rates, further compounding the problem. Over half the CMHC's assets are made up of mortgage-backed securities that they themselves guarantee. Turning from a net buyer to a net seller of MBS will have a profound impact on the mortgage market.
In fact, it appears that the CMHC doesn't even consider credit risk an issue since they make absolutely no allowances for it. Instead we're faced repeatedly with the statement that "CMHC’s liabilities are backed by the full faith and credit of the Government of Canada and there is no significant change in value that can be attributed to changes in credit risk." When an organization knows that it can get in to debt and guarantee anything it wants in the pursuit of profit, and be able to put the taxpayer on the hook for it all if it goes bad, is it any wonder that this is what happens?]]>http://www.mycfoweb.ca/2011/08/a-second-look-at-the-cmhc/feed/0Avoid the Landlord Pinchhttp://www.mycfoweb.ca/2011/08/avoid-the-landlord-pinch/
http://www.mycfoweb.ca/2011/08/avoid-the-landlord-pinch/#commentsThu, 11 Aug 2011 19:15:34 +0000Chris Horlacherhttp://www.mycfoweb.ca/?p=337If you’re an investor with significant real estate holdings, now may be the time to consider exiting this asset class in favour of brighter shores. The last few years have seen significant turmoil in real estate markets around the world. As of 2007, we have seen declines in the United States, Argentina, Britain, Netherlands, Italy, Australia, New Zealand, Ireland, Spain, Lebanon, France, Poland, South Africa, Israel, Greece, Bulgaria, Croatia, Norway, Singapore, South Korea, Sweden, Baltic states, India, Romania, Russia, Ukraine and China. In The Canadian Moral Hazard Corporation I pointed out that conditions were ripe for a sizeable decline in real estate valuations here in Canada. Since then, the US economy continues to deteriorate and this brings the collapse of our own real estate market closer with every day.

Income-seeking investors are of a different breed than speculators, who are in the game only to make short term gains on capital appreciation. Investors seeking cash-flow aren’t necessarily concerned with the fluctuations in their asset prices in the near-term. So long as their cash flow isn’t endangered they may be less likely to exit an asset class that has so far been very good to them. This may lead such investors to stay in real estate throughout the turmoil because they expect their cash flows to be unaffected. To these investors, an important metric to watch is the mortgage/rent ratio. It is very similar to P/E ratios for stocks in that it shows how the cost of owning an asset is related to the income that asset produces. It helps investors gauge whether a certain investment is “cheap” or “expensive”. In Canada, the cost of investing in housing has seldom been this expensive.

When metrics such as these travel so far from their historical means, corrections are inevitable. The correction to the imbalances illustrated above could come in two ways; 1) increased rents or, 2) decreased housing prices. Falling housing prices are a likely short term consequence of the coming economic turmoil but what about the government’s reaction and how will that affect the market? The government is 100% on the hook for all of the CMHC’s obligations and so they’re likely to engage in massive deficits. Due to the enormity of the CMHC’s guarantees relative to the national debt and annual spending these will be on a scale never before seen in the country. With deficit spending comes the threat of inflation and higher interest rates in the future, both of which spell trouble for income-minded investors.

With higher interest rates come higher costs for property owners. Those on variable-rate mortgages are likely to feel the pain first, while fixed-rate mortgage holders will see the higher costs arrive the next time their loans roll-over. These higher costs will erode the cash-flow created by their investments and they could soon find their properties costing them more than they earn.

The other threat is inflation. While inflation will wipe out any debt incurred to buy the properties, it endangers the income stream produced by them. Many provinces have limits on how much rent can be raised, which is nothing more than ‘soft’ rent-controls. A typical response to inflation is for governments to enact outright price controls, which destroys the ability of property owners to obtain any sort of real income from their holdings. Furthermore, with no income coming from the properties, the ability of sell them will become impaired and valuations will further plummet.

Higher interest rates and inflation will also necessarily bring down the value of mortgage-backed securities that have been flooding the market over the last decade. This is why I refer to this scenario as the landlord pinch, because real-estate investors of all types are facing pressures from every direction that threaten to destroy their capital and ability to derive an income from their investments. For the time being, the only way to avoid this appears to be a timely exit from the real-estate market. Income-seekers have many other options available to them that will get them through tough times and at myCFO, we can advise on how to effectively preserve your wealth.

]]>http://www.mycfoweb.ca/2011/08/avoid-the-landlord-pinch/feed/0Can Precious Metals Save Your Portfolio?http://www.mycfoweb.ca/2011/08/can-precious-metals-save-your-portfolio/
http://www.mycfoweb.ca/2011/08/can-precious-metals-save-your-portfolio/#commentsTue, 09 Aug 2011 18:05:53 +0000Chris Horlacherhttp://www.mycfoweb.ca/?p=310
Central banks the world over have been using US dollars as reserves, which prop up the value of their own currencies. This is a remnant of the Bretton-Woods system, where the US dollar was pegged to gold at $35/oz and then used as central bank reserves. This system created the impression that all the world's currencies were backed by gold through the US dollar. If the dollar was ever in peril, those central banks could redeem the dollars for gold. That all collapsed on August 15, 1971 when President Nixon terminated the gold redeemability of the dollar because a run on the currency was imminent. France was demanding the redemption of their US dollars in to gold and the world would soon follow suit as the cat was out of the bag and foreign governments were taking notice of the fact that the USA didn't have enough gold to cover its obligations. The system has limped on ever since and the rush back to gold is now underway.
The annual returns on gold and silver have been spectacular:

2005

2006

2007

2008

2009

2010

Gold

17.77%

23.92%

31.59%

3.41%

27.63%

27.74%

Silver

30.43%

46.09%

14.42%

-26.90%

57.46%

80.28%

Precious metals have served as money and a store of value for thousands of years. Recent research has proved gold's usefulness and importance in the world economy. Investors should take heed because they stand to reap immense benefits. A report published October, 2010 by the highly respected World Gold Council, concluded:

We believe gold's role extends beyond affording protection in extreme circumstances. In previous studies, the WGC has shown that including gold in a portfolio can reduce the volatility of a portfolio without necessarily sacrificing expected returns. However, we now find that portfolios which include gold are not only "optimal" in the sense of delivering better risk-adjusted returns, but that they can also help to reduce the potential loss. Specifically, we show that gold can decrease the Value at Risk (VaR) of a portfolio. We find that even relatively small allocations to gold, ranging between 2.5% and 9.0%, help reduce the weekly 1% and 2.5% VaR of a portfolio by between 0.1% and 18.5% based on data from December '87 to July '10. Moreover, looking at past events typically considered to be tail risks, such as Black Monday, the LTCM crisis, the recent 2007-2009 recession, etc., we find that in 18 out of 24 cases (75%) analysed, portfolios which included gold outperformed those which did not. In particular, in the period between October '07 and March '09, an asset allocation similar to a benchmark portfolio, which included an 8.5% allocation to gold, was able to reduce the total loss in the portfolio by almost 5% relative to an equivalent portfolio without gold. In other words, adding gold saved about US$500,000 on a US$10mn investment. – Gold: Hedging Against Tail Risk ,http://www.gold.org/investment/research/

Another study by the same organization, published in April 2011, went even deeper and studied not just how portfolios with gold perform during crises, but in good times as well:

An investor with an asset allocation similar to a simple benchmark portfolio (50% equities, 40% fixed income, 10% commodities) during 2008 would have reduced portfolio losses by between US$200,000 to US$400,000 on a US$10mn investment by allocating 5% to 10% of the overall portfolio directly to gold. Furthermore, over the past 20 years, the same investor would have increased the average annual portfolio gains by between US$100,000 to US$200,000 by directing a similar allocation to gold. These findings suggest that portfolio managers and investors who already have exposure to commodities in their portfolio stand to benefit from including gold as a separate strategic asset class, without compromising long-term returns. – Gold: A Commodity Like No Other ,http://www.gold.org/investment/research/

A detailed study published by Oxford Economics in July 2011 notes similar properties for gold:

...gold performs relatively strongly in a high inflation scenario and also does comparatively well in a deflation scenario derived from a wave of defaults in the 'peripheral' eurozone countries... We find that because of its lack of correlation with other financial assets, gold has a useful role to play in stabilising the value of a portfolio even if the conservative assumption of a modest negative real annual return is made. – The Impact of Inflation and Deflation on the Case for Gold ,http://www.gold.org/investment/research/

While it may seem strange to some that gold appears negatively correlated with other financial assets, considering its history as money this is not so strange. Gold appreciates faster than most financial assets in inflationary scenarios (when central banks are creating new currency) and depreciates slower than most financial assets during deflationary scenarios (market crashes). It acts as a sort of suspension system for portfolios, smoothing out areas of high volatility through countercyclical movements in price.
Due to the strong performance of precious metals, I am recommending it to all of our clients. Because of continued uncertainty in the market and volatility, precious metals will serve as a solid way to preserve and expand the value of our portfolios.]]>http://www.mycfoweb.ca/2011/08/can-precious-metals-save-your-portfolio/feed/0